Liabilities Are Still Weighing On Coty's (NYSE:COTY) Earnings A Year After The Turnaround Plan

By Sasha Jovanovic, CFA

Coty (NYSE:COTY) recently ended a period that saw its lofty ambitions end in difficulty and disappointment. Somewhat poetically, its time as an S&P 500 company bookended this period almost perfectly after it was added in late 2016 and subsequently dumped last September. This time saw an acquisition spree, equity issuance, rising debt levels and culminated in restructures, sales of businesses, class actions, CEOs on a turnstile and a potentially costly private placement. With the stock seemingly back in favour after a strong couple of weeks where its share price has more than doubled, investors might be curious to know if the company now ready to move on or are the spectres of the last few years still lingering?

Check out our latest analysis for Coty

Coty Acquisitions Led To Major Problems

Even for a company like Coty which is over 100 years old and has a large range of established premium brands, profits were difficult to come by in the years leading up to 2015.

That year, interim CEO Lambertus Becht struck an agreement to acquire 43 beauty brands from Procter & Gamble (NYSE:PG) in a deal that ultimately cost $11.6b in equity and debt. This transaction was lauded as transformational, with management citing the combined businesses of Coty would see revenues double to $9.2b a year based on historical performance.

However, it never achieved anywhere near this level of sales. The complex transaction saw shareholders diluted as the register ballooned from newly introduced P&G shareholders, who received stock in Coty as part of the deal. Making matters worse, the poor performance of many of its acquired businesses, including the P&G brands, led to declining revenues, writedowns and consistent losses.

_{NYSE:COTY Earnings and Revenue History as at 25 Nov 2020. Source: Simply Wall St}

What Did It Do To Fix The Problem?

Two CEOs later, Pierre Laubies and the board recognised the company was not on the right path. Debt had risen dramatically and interest cover was falling rapidly, meaning the company debt serviceability was looking increasingly challenging. Indeed some of its debt contained internally calculated net debt/EBITDA covenants (financial requirements set by the lender on the borrower), which would have been very tight if not breached.

A turnaround plan was drafted to cut costs by reducing the number of products, optimising the supply chain, outsourcing more production and ultimately cutting employee numbers. The overall aim was to improve the company's margins and reduce its debt significantly. This was a costly exercise, requiring a $600m investment over 4 years.

Just when it seemed there might be a way out, the financial situation went from bad to worse with the start of the pandemic. Sales of cosmetics and fragrances globally fell off a cliff as people spent more time at home which significantly reduced demand for these products in general. Drastic action had to be taken and it eventually was with the sale of its Professional Beauty and Retail Hair businesses in May this year for $4.3b to private equity firm KKR (NYSE:KKR) .

However, the cash injection came at a cost. Coty agreed to offer KKR $1b worth of new preference shares with a whopping 9% dividend. What's more, these shares can be converted to ordinary stock after 3 years at a price of $6.24, just 3% above the last traded price. Converting all of these shares would give KKR a 17.6% stake in Coty, significantly diluting current shareholders.

So while the sale of these businesses to KKR were welcome from a debt reduction point of view, they have now added a new repayment burden and potentially sold off a large portion of the company very cheaply.

Risks On The Path Out Of Indebtedness And Unprofitability

Coty's new financial burdens and structural changes will affect its performance. Below we have a look at what kind of impact we can expect from these moving forward.

1. Debt

_{NYSE:COTY Debt and Equity Analysis as at 25 Nov 2020. Source: Simply Wall St}

Since 2018, Coty has had access to a set of three senior unsecured notes and another set of three credit facilities. It is not known precisely what interest rates the credit facilities attract, so we have made some assumptions around base rates and currency splits in the credit facilities, but we estimate that the current situation looks something like this:

_{Note: Senior notes total debt value is as at origination (2018) converted to USD using today's rates. Source: Company Filings}

So from debt alone, the company has obligations of around $278m per year at current levels of debt. In comparison, excluding amortisation payments, the company had debt obligations of $223m in FY18 and $252m in FY19. The bottom line is, there is still no meaningful reduction in debt obligations a year on from the turnaround plan.

2. KKR preference shares

In addition to debt repayments, the company must now pay $90m worth of dividends per year to KKR under the preference share deal. This has increased the company's financial obligations by one-third. It's hardly an ideal scenario.

Meanwhile existing shareholders will have no right to a dividend under Coty's agreement with its creditors who have offered a covenant holiday for the company to get its leverage back under control, on the proviso that no dividends be paid to ordinary shareholders. Furthermore, these shareholders have the risk of being heavily diluted if KKR decides to convert their preferred shares in 3 years.

3. Company restructure and business activity

With the business being severely hampered by COVID-19, cost reductions and asset sales are high on the agenda. At the end of last financial year, the company had found $600m of annual fixed cost savings, of which $200m is expected in FY21.

While outsourcing of production can sound like a good idea with the quick savings available and reduction in business complexity, there are also major risks in handing over control of production. Coty will be more reliant on third parties for quality control, security of supply and also protection of any packaging or manufacturing intellectual property. Any quality issues could cost the company dearly in lost sales and brand/reputational damage.

The company still found the time to embark on further major acquisitions like the $600m deal for a 51% stake in Kylie Jenner's Kylie Cosmetics. This deal was surrounded with controversy around intellectual property in the production process and speculation around the actual size and growth levels of the business. Acquisitions like these aren't necessarily in line with a company increasingly eager to cut costs and debt.

In addition to the production and supply chain risks, we also noticed another warning sign for Coty to consider in your research.

Conclusion

Analysts believe that the company will return to profitability by next year, primarily by cutting costs as a jump in sales seems elusive. Indeed the first quarter was profitable which is a good start. However, the cost cutting drive is being hampered by additional financial obligations from debt and preference shares.

_{NYSE:COTY EPS Growth Forecast as at 25 Nov 2020. Source: Simply Wall St}

In our opinion, Coty needs to manage its supply chain restructure and outsourcing of manufacturing properly and continue focusing on simplification rather than acquisitions. Otherwise it is at risk of failing to adequately turn around the business and could even face difficulties meeting debt covenants on leverage once the covenant holiday ends.

In fact, Coty currently fails 3 of our 6 Financial Health checks. Click here to see our full analysis of the company's current financial position .

Neither Simply Wall St analyst Sasha Jovanovic nor Simply Wall St hold any position in any of the companies mentioned. This article is general in nature. It does not constitute a recommendation to buy or sell any stock and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

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